Thursday, January 29, 2015

Will the Fed Make a Monumental Mistake?

Jeffrey Gundlach says the Federal Reserve is on the brink of making a big mistake.

U.S. central bankers have been talking about raising benchmark borrowing costs this year even though the outlook for global growth is worsening as oil prices tumble. If Fed Chair Janet Yellen goes ahead with this plan, she runs the risk of having to quickly reverse course and cut interest rates, according to Gundlach.

“There’s no fundamental reason to raise interest rates,” Gundlach, chief executive officer at DoubleLine Capital LP, said at a conference yesterday in Hollywood, Florida. “My idea is the Fed raises rates for philosophical reasons. That may be short-lived.”

Policy makers concluded a two-day meeting in Washington today. The Fed maintained its pledge to be “patient” on raising interest rates and boosted its assessment of the economy and labor market, even as it expects inflation to decline further.

Yellen said in December that being patient meant such a tightening wouldn’t happen “for at least the next couple of meetings,” or not before late April.

Bond traders would seem to share Gundlach’s concern that the Fed may be getting ahead of itself with its road-map for an exit from six years of near-zero interest rates.

Inflation Outlook

They are pricing in annual inflation of about 1.33 percent during the next five years, short of the Fed’s 2 percent goal, based on break-even rates for Treasury Inflation Protected Securities. Oil prices have fallen to $44.28 a barrel from $107.26 in June.“I would bet a great deal of money that oil’s not going to go to $90 by year-end,” Gundlach said.

While things are generally looking up for the U.S. economy, it’s unclear how long that can continue in the face of tepid growth elsewhere. The strengthening dollar is another cause for concern, mainly because it makes it more expensive for countries with less valuable currencies (which is almost all of them) to import U.S. goods.

This already appears to be eating into the earnings of companies such as Procter & Gamble Co., Pfizer Inc. and DuPont Co.

Despite this backdrop, most analysts expect central bankers to go through with some sort of tightening this year. Money-market derivatives traders are pricing in a rate increase in the fourth quarter, too.

In sharp contrast, there are others like T. Boone Pickens and more recently, Daniel Yergen, who think crude's discount days are numbered. But with oil prices now hovering at near six-year lows after the government reported record-high inventories in the United States, it's raising anxieties about the global oil glut that has pressured the market since last summer.

And it's not just an oversupply story. As Jim Keohane, CEO of HOOPP recently told me when we discussed whether pensions are systemically important, the plunge in oil is worrisome because the "drop in commodities is so severe that it implies demand factors are driving it."

Indeed, demand is falling fast as global economic weakness gains steam, which is surely one reason why Goldman now forecasts oil prices hitting $30 a barrel in an extended slump.

“Part one, the world is consuming about 90 million barrels a day,” said Wiseman, chief executive officer of the Canada Pension Plan Investment Board. “Part two, God isn’t making any more.”

Wiseman said that simple supply and demand perspective all but guarantees oil prices will be higher 10 years down the road, offering investment opportunities now for the C$234 billion ($188 billion) fund.

“I’ll take that bet” on oil’s rebound, he said in an interview Tuesday at Bloomberg’s Toronto office.

I respectfully disagree with Mark Wiseman's simple supply/demand argument but I also understand why he's taking the long, long view on all of CPPIB's investments. And in the very long-run, he may turn out to be right, but over the next few years these investments in energy could suffer a lot more pain, especially if global deflation hits us.

You know my fears. I already think we're undergoing a transformational shift unlike anything we've ever experienced. This time is really different as Gundlach has warned us. But as he and other well known hedge fund managers warn us of a catastrophe in equities, I think they're running way ahead of themselves.

Importantly, there is still plenty of liquidity in the global financial system to drive risk assets much, much higher, but Gundlach raises an excellent point, if the Fed goes ahead and raises rates at this juncture, it will be the biggest policy mistake ever because it will all but ensure global deflation.

I personally think the Fed won't raise rates. Let's go over the latest FOMC statement released on Wednesday (emphasis is mine):

Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace. Labor market conditions have improved further, with strong job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow. Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

The bond market is telling the Fed to take global deflation a lot more seriously, which is why U.S. bond yields are falling to record low levels and long bonds (TLT) continue to perform well and why the mighty greenback is surging higher.

Some aren't concerned by the surge in the mighty greenback. Below, Pimco's CIO, Scott Mather, tells CNBC why the strong U.S. dollar will not derail the Fed's decision to hike rates this summer.

And Bill Gross, Pimco's former CIO who now works for Janus, tells CNBC why the Federal Reserve will cautiously raise interest rates this year, but investors need not panic.

I beg to differ with Mather and Gross and agree with Gundlach. Moreover, I agree with those who say the Fed is cornered and won't raise rates, especially with all the political uncertainty in Europe. If it does raise rates, it will only exacerbate global deflationary headwinds and bring about an epochal deflationary crisis that Lawrence Summers warned of.

Unfortunately, no matter what the Fed and other central banks do, global deflation is coming, and it will pummel institutional and retail investors who are ill-prepared for the epochal storm ahead.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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